Is the U.K. on the Brink of a Recession?

U.K. borrowers are beginning to feel the credit pinch a la U.S. style. And it's not just the risky ones that are seeing the doors close on lending.

That the nonconforming lending market has had to reshape itself in the wake of the subprime debacle is no surprise. However, the U.K. is beginning to see selectivity even in prime lending, leaving higher-rated borrowers with nowhere to run.

The contraction in U.K. mortgage lending was highlighted by a recent Bank of England (BoE) report on U.K. credit conditions. This survey of the country's mortgage lenders found that both secured and unsecured credit to households was sharply reduced in the three months leading up to mid-March. The reduction in lending, the survey showed, was achieved primarily through tightening credit standards, including limiting LTVs and increasing loan margins.

But as most originators withdraw products, mortgage lenders that offer the best rates are now overwhelmed by demand. Some have responded by withholding products to new customers.

"The U.K. mortgage market has turned into one of worsening mortgage offers as anyone providing the best mortgage rates is rapidly overwhelmed by demand," Societe Generale analysts said. "The number of mortgages on offer has declined significantly in recent months, initially driven by nonconforming products, but more recently by these prime lenders."

Borrowers should expect conditions to worsen as lenders said they will further tighten credit standards in the second quarter. Of the respondents to the BoE survey, a net 41% stated that LTVs will be reduced, with 19% saying that they had already reduced LTVs in the first quarter.

Meanwhile, 61% of the lenders surveyed said they had increased secured loan margins in the first quarter and 26% expected further increases - the average rate available for a GBP5,000 ($9,876) unsecured loan today stands at 7.7% compared with 6.5% last year. Credit scoring was also under pressure as a net 44% of respondents stated loan criteria had tightened and 46% expected further tightening.

The survey also showed a further widening in spreads, suggesting a muted impact from the base rate reductions that have been made. "The Bank of England's credit conditions survey last week highlighted what most people already knew - that banks do not want to lend as much money," SocGen analysts said.

With these dreary prospects pervasive in the market, it is hard to understand why any economist might still believe that the U.K. could still beat a recession. The U.K. has been dependent on its mortgage market over the past year, and the nation's healthy consumer sentiment has been largely sustained by rising home prices. The two are inextricably linked.

Halifax reported house prices have fallen by 2.5% in March on a month-over-month basis, the largest drop since September 1992 and lenders have warned that defaults and losses on secured household credit could increase further in the near term.

Now the formula begins to shift. Consumers not only have to face hefty levies on mortgages they can't switch out of, but must also face the prospect of owing more than what their property is currently worth.

This phenomenon is likely to cause a downward swing in consumer confidence, and the question now is whether this will serve as the breaking point that finally drives the U.K. economy into recession.